The examples, summarised in the following table, discuss demerger factors and circumstances that are particularly relevant for small to medium enterprises. :

Example no.

Category

1

2

3

4

5

6

7

8

9

Plans to dispose of interests in either demerged or head entity at time of demerger

Yes

Yes

Yes

Yes

Yes

Yes

Succession and estate planning

Yes

Yes

Yes

Yes

Different types of businesses operated within a corporate group

Yes

Yes

Yes

Yes

Yes

Shares acquired after 20 Sept 1985

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Shares acquired before 20 September 1985

Yes

Yes

Shares subject to CGT discount or other concession

Yes

Yes

Yes

Yes

Yes

Yes

Profit accumulations and pattern of distributions

Yes

Yes

Yes

Yes

Yes

Separating family arrangements or closely held groups where demergers done for specific shareholders

Yes

Yes

Yes

Yes

Asset protection

Yes

Yes

Yes

Yes

Yes

Employee share schemes

Yes

Yes

Yes

Yes

Management issues

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Equity raising

Yes

Yes

Yes

Example 1: Company wishing to acquire a rival business

The facts

Jellyco Pty Ltd, an Australian resident company, operates two businesses: an importing/wholesaling business in electrical components and a business of manufacturing lamps. The shareholders of Jellyco are made up of Australian resident individuals and one company. Fred, Sally, Cameron and Simon are all directors of Jellyco. Fred and his wife Sally own the majority of shares in Jellyco.

Jellyco owns all the issued capital in Zapco Pty Ltd. Zapco owns real property currently valued at $1,000,000. Shares in both Jellyco and Zapco were acquired after 20 September 1985.

Jellyco decides to undertake a corporate restructure so it can solely focus and expand its core business of importation and distribution rather than its manufacturing business. Accordingly, Jellyco transfers its manufacturing business (including plant, equipment, key intellectual property and staff) to Zapco at market value, with the intention that Zapco operate an independent business of manufacturing lamps.

Jellyco also wishes to expand its importation/distribution business by acquiring the business of a rival which it has been negotiating with. Part of the purchase price Jellyco is offering to acquire the rival business is granting the owners of the rival business an equity stake in Jellyco via a new issue of shares. Certain venture capitalists will also be provided an equity stake in Jellyco for providing funds to help acquire the rival business.

If the takeover of the rival business is successful, key employees in both Jellyco and the rival business will also be given the opportunity to buy shares in Jellyco.

To help effect its corporate restructure and business expansion, Jellyco wishes to conduct a demerger of Zapco, which it claims will facilitate the takeover of the rival business and enhance the long term business prospects of both Jellyco and Zapco.

Currently, Jellyco has paid up share capital of $45,000 and a net market value of $4,300,000. The net market value of Zapco is $2,000,000 ($1,000,000 of this value relating to its real property). Zapco's real property is used 50% for its business operations and the other 50% is rented to Jellyco for its business. Fred is Zapco's sole director.

Jellyco shareholders have no plans to dispose of any of their shares in Jellyco or a demerged Zapco after the demerger.

Applicant's stated reasons for demerger

Jellyco states a demerger would provide the following commercial benefits:

A demerger would help facilitate Jellyco taking over the rival business. Currently, the pre-demerger price of Jellyco is unduly high due to its ownership of Zapco. This hinders the owners of the rival business, their key employees and venture capitalists acquiring an interest in Jellyco, as they would be required to pay a premium to acquire an indirect stake in Zapco. A demerger would allow these parties to acquire an interest in the business of Jellyco only. This is important as offering equity in Jellyco to the above parties is a key factor to help the company take over the rival business;

A demerger would assist key employees in both Jellyco and the rival business to acquire an equity interest in Jellyco. This should assist the profitability of Jellyco, as these employees have extensive experience and skills in importing and wholesaling electrical products. Without the demerger it would be difficult to grant employees an equity stake, as it would mean giving employees an indirect interest in Zapco's real property and business; and

Asset protection – as Zapco is a wholly owned subsidiary of Jellyco, its real property and other assets are indirectly exposed to Jellyco's creditors in the event that Jellyco is subject to liquidation.

Commissioner's analysis and decision

On examining the proposed demerger together with the relevant circumstances in subsection 45B(8), the Commissioner accepts the applicant's stated reasons above are positive relevant circumstances that are likely to improve the business structures of both Jellyco and Zapco. The applicant's statement that the shareholders of Jellyco have no current intention of disposing of any of their interests in either Jellyco or Zapco after the demerger is also a relevant factor (paragraphs 73 to 78 of PS LA 2005/21).

Accordingly, in the absence of any evidence that is inconsistent with the above, the Commissioner would not make a determination under subsection 45B(3) that sections 45BA or 45C of the ITAA 1936 apply to the proposed demerger.

Example 2: Corporate group merging with another business

The facts

Lammat Pty Ltd owns and operates a grain broking business. It also owns 100% of the issued capital in two subsidiaries, Landco Pty Ltd and Grainbrok Pty Ltd. Grainbrok is also involved in grain broking and is affiliated with Lammat's grain broking business, while Landco owns and operates a separate farming business.

Han owns 100% of the issued capital in Lammat. All shares in Lammat were acquired by him before 20 September 1985. Lammat's shares in Landco were also acquired before 20 September 1985. Han is a director of both Lammat and Landco.

Management and staff in Lammat have dual roles. They manage both a broking business (Lammat) and a farming business (Landco). Until recently, it was common for Lammat to fund activities and capital improvements to the property of Landco.

Lammat is currently negotiating with another grain company to do a merger with their grain broking business. Part of this merger plan involves demerging Landco, so that Lammat and Grainbrok can form a pure grain broking corporate group.

Applicant's stated reasons for demerger

Lammat states a demerger would provide the following commercial benefits:

separating the two businesses (grain broking and farming), which have different commercial drivers

facilitating the merger negotiations with the other grain company, who do not want to be involved indirectly with the farming business operated by Landco

enabling flexible financing arrangements for the new grain broking group. After the demerger, finance will be secured over the trading inventory of the grain broking group business, rather than using Landco's farm property as part of the security

providing asset protection for the farming property. Currently the property is at risk should Lammat run into financial difficulties;

the net profit of Lammat will no longer support Landco's farming business, enabling accurate reporting of Landco's financial viability

enabling the allocation of staff and management to the separate businesses of the demerged entities enabling focus on business outcomes without conflicting priorities

Han does not intend to sell his shares in either of the demerged businesses at the time the demerger is proposed

allowing Han to take direct interests in Landco for Han's estate planning purposes.

Commissioner's analysis and decision

In examining the current demerger proposal in relation to the relevant circumstances stated in subsection 45B(8), the Commissioner took into account the following factors:

The taxpayer's reasons for demerger, including 'separating the two businesses as they have different commercial drivers', to enable more 'flexible financing arrangements' and separating management, are very common reasons given in demerger cases. While these factors are relevant, the Commissioner does not automatically accept or dismiss these reasons, but requires proper details to establish what weight should be accorded these factors.

In this particular case, the Commissioner accepts that the applicants stated reasons above except the last point, are likely to improve the business operations of both Lammat and Landco, with any tax benefits being incidental.

Another important positive factor is Han's assertion that he has no intention to dispose of his interests in Lammat or Landco after the demerger (paragraphs 73 to 78 of PS LA 2005/21).

Regarding Han's estate planning however, the Commissioner would not consider this a relevant factor in supporting the business efficiency merits of a demerger of Landco from Lammat (paragraphs 22 & 23 of PS LA 2005/21).

Accordingly, the Commissioner would not make a determination under subsection 45B(3) that sections 45BA or 45C of the ITAA 1936 apply to the proposed demerger.

Example 3: Demerger of subsidiary to promote its business development

The facts

Realco Pty Ltd owns 100% of the issued capital in Keljo Pty Ltd, which operates a substantial pizza business and also owns passive investments in companies on the Australian Stock Exchange. During the relevant income year, the estimated market value of Keljo is approximately $3,000,000.

Realco operates a successful property development business and owns land originally acquired as an investment. The land has a current value of approximately $2,000,000.

All shares in both Realco and Keljo were acquired before 20 September 1985.

Realco now wishes to develop the land it owns into a luxury hotel resort. The hotel project will cost approximately $10,000,000, which Realco intends to raise by issuing new shares in Realco via a public listing.

However the current owners of Realco don't want any new shareholders in Realco (via the public listing) having any indirect interest in Keljo. Commercial research has also indicated that Realco's proposed public listing would not be viewed favourably by the market, if Realco indirectly owns Keljo's pizza business.

Accordingly, as part of the hotel project scheme, Realco proposes to demerge Keljo. Realco also affirms that none of its shareholders intend to dispose or otherwise deal with their shares in either Realco or Keljo after the demerger.

Applicant's stated reasons for demerger

Realco states a demerger would provide the following commercial benefits:

A demerger will assist in the public listing of Realco, as new investors will not have to pay an extra premium to pay for the assets of Keljo.

A demerger will allow the totally different businesses of Realco and Keljo to develop independently of each other.

Asset protection – a demerger will ensure Keljo's established business and passive investments are protected from the financial risks associated with Realco's hotel resort development.

Commissioner's analysis and decision

The Commissioner accepts that the demerger was being undertaken to create two distinct companies operating significantly different businesses, a property development business and a pizza business.

The Commissioner accepts the applicant's stated reasons above constitute positive relevant circumstances, as provided for in subsection 45B(8), that are likely to improve the business structures of both Realco and Keljo. The applicant's statement that the shareholders of Realco have no current intention of disposing of any of their interests in either Realco or Keljo after the demerger is relevant (paragraphs 73 to 78 of PS LA 2005/21).

Accordingly, in the absence of any evidence that is inconsistent with the above, the Commissioner would not make a determination under subsection 45B(3) that sections 45BA or 45C of the ITAA 1936 apply to the proposed demerger.

The facts

Sam owns 100% of the issued capital in Engin Pty Ltd and is its sole director. Engin owns 50% of the issued capital in Subang Pty Ltd. The other 50% of issued capital in Subang is owned by Amanda.

Both Engin and Subang operate successful engineering businesses, although both companies operate in different localities and have different segments of the engineering market.

Sam paid $1,000 for his shares in Engin, and Engin paid $2,000 for its 50% stake in Subang. All the shares in both Engin and Subang were acquired after 20 September 1985.

Although both Engin and Subang have paid dividends to their shareholders in previous years, considerable profits have been retained resulting in increased share value. Engin has a current market value of $1.9 million (with $1.4 million of this value relating to Engin's holdings in Subang).

Sam acknowledges he was negotiating to dispose of Engin's shares in Subang to a third party (an employee of Subang). These negotiations fell through however due to a failure of Sam and the employee agreeing on the sale price. The negotiations were not conditional upon a demerger.

Applicant's stated reasons for demerger

Sam states a demerger would provide the following commercial benefits:

Sam is conducting negotiations to sell 50% of his shares in Engin to Lucy, an employee of Engin. The proposed sale is conditional on a demerger occurring, as there has been an established history of conflict between Lucy and the half owner of Subang, Amanda. For the last 10 years, Lucy and Amanda have taken legal action against each other over various commercial and civil disputes. Accordingly, Lucy doesn't want to acquire an indirect interest in Subang, due to the high risk of disputes occurring with Amanda. Any disputes may affect the business performance of both Subang and Engin.

Admission of new equity participants into the business of Engin will enhance its performance, as these new equity participants will have a stake in the business.

A demerger will allow a separation of risk should either business fail.

Commissioner's analysis and decision

In examining the current demerger proposal in relation to the relevant circumstances in subsection 45B(8), the Commissioner took into account the following factors:

The significant profit accumulations in both Engin and Subang. This is of particular importance given that the investment in Subang had a cost of only $2000 and the company now has a market value of $1.4 million (paragraphs 57 to 58 of PS LA 2005/21).

A demerger would deliver significant tax concessions to Sam in that due to the large profit accumulations in Subang, a large tax free demerger dividend of $1.4 million would be paid to him (paragraphs 94 to 95 of PS LA 2005/21).

The proposed subsequent sale of Sam's 50% stake in Engin is significant as it indicates the tax effective disposal of the Engin shares is a significant factor of the scheme (as this sale would be entitled to the CGT discount). Therefore a significant purpose of the demerger is arguably the tax concessions granted to Sam (paragraphs 73 to 78 of PS LA 2005/21).

A demerger would not enhance the effectiveness of asset protection for Engin should Subang's business fail, as Engin is a separate legal entity from Subang.

While a demerger would provide some asset protection for Subang should Engin's business fail, this factor alone does not preclude the application of section 45B.

While Lucy's conflict with Amanda may be a factor, where there exists more than one purpose for a demerger, the tax purpose must be incidental and subordinate to the other substantial purpose or purposes. It is the Commissioner's view that a substantial purpose in this case is to obtain a tax benefit for Sam (paragraphs 43 to 45 of PS LA 2005/21).

It is acknowledged that the introduction of an experienced employee as an equity owner in Engin is a relevant factor and may increase productivity and profit. However where there exists more than one purpose for a demerger, the tax purpose must be incidental and subordinate to the other substantial purpose or purposes. It is the Commissioner's view that the substantial purpose is to obtain a tax benefit (paragraphs 43 to 45 of PS LA 2005/21).

Based on the above facts, the Commissioner would exercise his discretion to make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies to the demerger benefit provided to Sam under the scheme.

The facts

Sally, Mandy and Anne each own a third of the total shares in Chowder Pty Ltd (Chowder) which operates the Chowgood restaurant. Chowder also owns 100% of the issued capital in Vegan Pty Ltd (Vegan). Vegan operates the Vege Delight Restaurant. Both the share capital of Chowder and Vegan can be precisely identified as $80,000 and $30,000 respectively. All shares in Chowder and Vegan were acquired after 20 September 1985.

Both Chowder and Vegan operate successful restaurants. The estimated market value of Chowder is $1.5 million (this includes its indirect interest in Vegan) and the estimated market value of Vegan is $500,000.

In previous income years both Chowder and Vegan paid regular large dividends to their shareholders. In 2004, Chowder paid $300,000 in dividends and in 2005 paid $350,000.

In the 2006 income year Chowder did not distribute its net profit. Instead, although Chowder had an operating profit of $250,000 and received a dividend of $200,000 from Vegan, it only declared dividends of $40,000.

In August 2007, Sally, Mandy and Anne decide to demerge Vegan from Chowder. However, the demerger benefit of Vegan shares to Sally, Mandy and Anne does not reflect a correct attribution between capital and profits.

It was agreed that the following would happen once the demerger was completed:

Sally will sell some of her shares in Chowder to Phillip, who is the restaurant manager of Chowgood

Sally would sell the remainder of her shares in Chowder to Mandy and Anne, and

Sally would retain her shares in Vegan.

Applicants stated reasons for demerger

The following reasons were provided by Sally, Mandy and Anne for the demerger:

The demerger would allow the owners of Chowder to separate their equity interests in both Chowder and Vegan and deal with these interests separately. This is not possible under the current structure where Vegan is a wholly-owned subsidiary.

Although Sally would like to dispose of her interests in Chowder, she wishes to retain her shareholding in Vegan. This is not possible under the current structure.

A demerger would allow persons wishing to acquire an equity stake in one restaurant but not the other to acquire shares in either Chowder or Vegan. This is not possible under the current structure.

A demerger would facilitate Phillip, the manager of the Chowgood restaurant, acquiring shares in Chowder.

The above factors would facilitate a more efficient running of the businesses, by having separate equity ownership for both companies.

Commissioner's analysis and decision

In examining the current demerger proposal in relation to the relevant circumstances in subsection 45B(8), the Commissioner took into account the following factors:

There was a clear interruption of the pattern of profit distribution by Chowder in the 2006 income year. There was no apparent business purpose for the concentration of these profits in Chowder before the demerger and this interruption was also inconsistent with past dividend practice (paragraphs 57 and 84 to 95 of PS LA 2005/21).

The clear interruption of the pattern of profit distribution in Chowder before the demerger clearly benefits Sally, as it effectively converts what would otherwise be dividend income into a tax beneficial capital amount. This is significant as Sally would be entitled to the CGT discount on any subsequent sale of the Chowder shares, as she has held these shares for more than 12 months. This would provide Sally with a significant tax benefit (paragraphs 84 to 95 and 107 to 108 of PS LA 2005/21).

The demerger allocation of Vegan shares to Sally, Mandy and Anne did not reflect a correct attribution of capital and profits (paragraphs 49 to 56 of PS LA 2005/21).

The prearranged disposal of Chowder after the demerger suggests that it was undertaken to transfer corporate assets to shareholders rather than restructure the businesses of the respective companies (paragraphs 73 to 78 of PS LA 2005/21). It is also clear on the facts provided that the demerger was conducted for a more than incidental purpose to facilitate the tax effective disposal of Sally's shares in Chowder.

After the demerger there were no alterations to the business operations of either Chowder or Vegan, other than the sale of shares to the manager of the Chowgood restaurant.

While Sally wishing to retain her interests in a demerged Vegan is a relevant factor, where there exists more than one purpose for a demerger, the tax purpose must be incidental and subordinate to the other substantial purpose or purposes. The Commissioner's view is that the substantial purpose in this case is to obtain a tax benefit for Sally and the other shareholders of Chowder.

While it is acknowledged that the manager of the Chowgood restaurant taking an equity stake in Chowgood may promote some business efficiencies, this factor does not result in the purpose of obtaining a tax benefit being reduced to an insignificant purpose (paragraphs 43 to 45 of PS LA 2005/21).

Based on the above facts, it is clear that a significant purpose of the proposed demerger and subsequent sale was to obtain a tax benefit. The tax benefits were to provide Chowder's shareholders with a tax free demerger dividend and entitle Sally to reduce her assessable income by applying the discount capital gain to the sale of her shares. The demerger also resulted in profits in Vegan being distributed as preferentially taxed capital to Sally, Mandy and Anne. The facts also do not disclose the intention to substantially improve business efficiency.

Accordingly, the Commissioner would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA would apply to treat the demerger dividend as assessable income to the shareholders of Chowder.

The facts

Zador Pty Ltd (Zador) conducts a business of importing, wholesaling and distributing widgets and other products.

Zador has three shareholders, Noddy Pty Ltd (holding three shares), Carol (holding one share) and Melissa (holding one share). Noddy is wholly owned by Ralph. Ralph is also the managing director of both Noddy and Zador. The shares in both Noddy and Zador were acquired post 20 September 1985.

Ralph is married to Carol and is Melissa's brother.

The corporate structure of Zador and its shareholders is shown below.

Zador and its shareholders pre-demerger

In the relevant income year, Noddy proposes a demerger of Zador. As a step just before demerger, Zador undertakes a one for ten share split in proportion to each shareholder's holding in the company. Accordingly after the share split, Noddy will hold 30 Zador shares and Carol and Melissa will hold 10 Zador shares each.

A day after the share split, Zador is demerged from Noddy. Ralph now holds the Zador shares previously held by Noddy as shown below:

Zador and its shareholders post-demerger

It was agreed between the parties that following the demerger, Ralph will sell five Zador shares each to Carol and Melissa. The consideration for the sale will be the current market value of the shares, being $500,000 per Zador share. Accordingly after the sale, Ralph's shareholding in Zador decreases to 20 shares and Melissa and Carol hold 15 Zador shares each.

Zador and its shareholders post Ralph's sale of shares

Applicant's stated reasons for demerger

The following reasons were provided by Noddy for the demerger:

it would simplify the shareholding structure of Zador for Ralph – by removing Noddy as a shareholder

Ralph's asset portfolio would be simplified

it would remove one layer of ownership and thereby reduce the administrative costs for the relevant entities

the management and shareholding decisions regarding Zador could be done directly through Ralph, rather than through Noddy

As Ralph is intending to take a less active role in the management of Zador, the share sale to both Carol and Melissa was designed to reflect their taking a more active management interest in the business.

Commissioner's analysis and decision

In examining the current demerger proposal in relation to the relevant circumstances in subsection 45B(8), the Commissioner took into account the following factors:

The facts indicated that the demerger was done to facilitate Ralph disposing of 20% of his total shares in Zador as soon as practicable after the demerger, rather than to promote any business efficiencies in either Noddy or Zador (paragraphs 73 to 78 and 89 of PS LA 2005/21).

The disposal (at market value) of the Zador shares by Ralph would be to related parties (paragraphs 81 to 98 of PS LA 2005/21).

The substance and effect of the scheme involves Ralph obtaining significant tax and financial benefits from the demerger and subsequent sale of 10 of his Zador shares. Ralph would be entitled to the CGT discount concession on the sale of these shares (paragraphs 94 to 95 of PS LA 2005/21).

The purposes mentioned by Noddy did not disclose any change or improvement to the businesses of the demerger group, apart from managerial changes which were not dependent on undertaking a demerger.

Some of the reasons for the demerger describe the effect of the demerger (that is, reducing administration costs, simplification of the NFT structure, management decisions being made by Ralph rather than Noddy) and these appear relatively insignificant.

In the absence of substantial business reasons for the demerger, the significant tax benefits obtained by Ralph assume greater significance (paragraphs 22 to 23 of PS LA 2005/21).

Based on the above facts the Commissioner would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies to the demerger benefit provided under the scheme.

Example 7: Scheme involving family arrangement and later disposal of ownership interests after demerger

The facts

In the relevant income year PEP Pty Ltd owned 100% of Sabu Products Pty Ltd. Sabu operates a business of manufacturing and marketing various commercial products. All shares in Sabu were acquired after 20 September 1985.

All shares in PEP are owned by six members of the Butcher family – Fred and Wendy Butcher and their four children, Al, Mark, Karen and Judy. Each family member has 10 ordinary shares in PEP which were acquired after 20 September 1985.

During the relevant income year, Sabu's managing director was Fred Butcher, with his son Al Butcher as technical manager. However bitter management disagreements between Al and Fred on how Sabu should be run occurred, which led to discord within the entire Butcher family.

The ongoing and continual feuds between Al and Fred encouraged the Butcher family members to agree to sell Sabu to Al's company, Al Butcher Pty Ltd. It was agreed between the family, that Sabu should be demerged from PEP before the sale.

Accordingly, on the same day the demerger occurred, Fred, Wendy and their children sold their demerged interests in Sabu to Al's company ABP and Fred resigned as Sabu's managing director. Al became Sabu's sole director and manager.

Applicant's stated reasons for demerger

PEP provided the following reasons for the demerger:

It was necessary for commercial reasons as Sabu's business future was in jeopardy due to the family disputes over its management.

Due to the disputes, it was crucial that changes were made to the ownership and management of Sabu to ensure no further disputes arose.

Commissioner's analysis and decision

In examining the current demerger proposal in relation to the relevant circumstances in subsection 45B(8), the Commissioner took into account the following factors:

The demerger was conditional on the subsequent sale of Sabu. They occurred on the same day. The facts indicate that the demerger was undertaken for a more than incidental purpose in moving the ownership interests in Sabu to the owners of PEP in a tax effective way, rather than facilitating a restructure of the Sabu business (paragraphs 73 to 78 and 89 of PS LA 2005/21).

While there is a genuine commercial reason for Al's company acquiring the shares in Sabu, where there exists more than one purpose for a demerger, the tax purpose must be incidental and subordinate to the other substantial purpose or purposes. The Commissioner's view is that a substantial purpose in this case is to obtain a tax benefit for the Butcher family members who sold their interests in Sabu. Although there is a significant non-tax reason to sell Sabu, there is no objective commercial explanation for the demerger discernible from the facts.

The Commissioner would take the view that the manner, form, substance and timeframe of the scheme all indicate that there was a significant purpose for the shareholders of PEP to obtain a tax benefit. Accordingly, the Commissioner would make a determination under paragraph 45B(3)(b) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the demerger benefit provided under the scheme.

Example 8: Scheme involving family arrangement and later disposal of ownership interests

The facts

SOC Pty Ltd owns 100% of the issued capital in Mode Pty Ltd.

SOC's business largely consists of investing activities and holding passive real estate investments. Mode carries on an aquaculture business. All shares in Mode were acquired after 20 September 1985.

Previously, SOC had carried on a manufacturing business. However it had received a damages claim against it in respect of one of its products that was later settled. As a result of the product liability claim it ceased its manufacturing business nine years ago.

On 30 June 2004, SOC was owned by James and his wife Heidi. All shares were acquired before 20 September 1985. At this time SOC had a market value of approximately $6 million. James is sole director and manager of both SOC and Mode.

For some years SOC has built up retained profits from dividend income received from Mode. At 30 June 2005, Mode had share capital of $20,000 and a market value of approximately $1.2 million.

In September 2004 James decides to demerge Mode from SOC, with all Mode shares distributed to SOC shareholders in proportion to their holdings. James's accountants also advised that a demerger would facilitate any future sale of Mode.

Both before and after demerger, James remained manager and director of both SOC and Mode. Both before and after the demerger Heidi continued in her role as bookkeeper of both SOC and Mode. The rest of the structure and management of both companies also remained the same.

In September 2005, the business of Mode was sold to an unrelated third party.

Applicant's stated reasons for demerger

The stated reasons for the demerger were to:

separate Mode from the potential of future product liability claims being made against SOC in respect of its now ceased manufacturing activities

allow the management of Mode to focus not only on its existing customer base but also to expand this base

allow management to focus on Mode's trading activities and invest the necessary time to grow the business without hindrance from the potential for future claims to be made against SOC

allow SOC to focus on its real estate investment business

facilitate any future sale of Mode.

Commissioner's analysis and decision

In examining the current demerger proposal in relation to the relevant circumstances in subsection 45B(8), the Commissioner took into account the following factors:

The facts indicated that the demerger was undertaken to dispose of Mode in a tax effective manner, rather than protect Mode from any potential liability claims made against SOC for its past manufacturing activities (particularly as the product liability claim against SOC occurred many years ago).

The management structure of both SOC and Mode has remained the same (with James acting as manager and director of both companies) both before and after demerger. The demerger did not bring about a separation of control in the decision making activities of either SOC or Mode.

With the management structure being the same both pre and post demerger, it's not apparent how a demerger allows management to focus more on the passive real estate business of SOC or assists the business activities of Mode.

The essential nature of the scheme allowed Mode shares to be received by SOC shareholders in a tax free form. In addition there has been a transformation of profits into a capital asset in the hands of SOC shareholders, who were then able to utilise the small business CGT concessions on the later disposal of the Mode business (paragraphs 43 to 45 and 84 to 95 of PS LA 2005/21).

The contemporaneous documentation suggests that the demerger was also done with a view to a future possible sale of the Mode business (paragraphs 73 to 78 of PS LA 2005/21).

Based on the above, it is not apparent that the demerger was entered into for commercial reasons. Therefore the tax benefits to the relevant shareholders of SOC have greater significance (paragraphs 22 and 23 of PS LA 2005/21). Due to the above facts, the Commissioner would make a determination under paragraph 45B(3)(a) of the ITAA 1936 that section 45BA of the ITAA 1936 applies to the demerger benefits provided under the scheme.

Example 9: Demerger of subsidiary due to several problems with current corporate structure

The facts

ACMORE Pty Ltd, which operates a legal practice, is owned equally by Larry, Jill and Gwen, each of whom owns 100,000 $1 dollar shares in the company. All ACMORE shares were acquired after 20 September 1985. While Larry, Jill and Gwen are the senior partners in the law practice, ACMORE also employs eight other senior and junior lawyers.

ACMORE also owns 100% of the issued capital (made up of 50,000 $1 dollar shares) in Malachi Mortgages Ltd. All of Malachi's shares were acquired after 20 September 1985. Malachi operates a mortgage business. Although Malachi has a share capital of only $50,000, it has approximately $2.3 million in retained earnings due to the success of its business. Larry, Jill and Gwen are directors of Malachi, along with four other independent directors.

Currently, both ACMORE and Malachi operate out of the same premises.

Applicant's stated reasons for demerger

Larry, Jill and Gwen now propose demerging Malachi from ACMORE for the following reasons:

The two companies have distinct separate businesses, with different management protocols, regulatory requirements, IT systems, employees, etc.

Immediately after the demerger of Malachi, the company will issue shares to new investors, who will provide additional capital that will be used to expand Malachi's mortgage business. These new shareholders, (who have extensive experience in the mortgage business) will also be appointed as directors of Malachi and are expected to improve its commercial performance.

A demerger will allow the separate board of directors to focus on their respective company's direction independently of the other company's regulatory and business requirements.

A demerger will facilitate employee share schemes that both companies wish to implement immediately after the demerger. It is asserted that the current corporate structure impedes implementation of effective employee share schemes, as any legal employee of ACMORE would have to pay a premium to buy an equity stake in ACMORE due to the company's ownership of Malachi. ACMORE states that its legal employees are not interested in investing or being involved in Malachi's mortgage business. It is also asserted that Malachi's employees are not interested in being linked to the incorporated law practice of ACMORE.

It is stated that employee share schemes (by the issue of new shares in the respective company) will encourage key staff to remain in both companies and will assist both businesses to grow and become more efficient.

As Larry and Jill are of retirement age, they intend to sell part of their interests in ACMORE to key employees over the next 5 to 10 years as part of succession planning for the business. This plan will allow the legal practice to continue smoothly, with new lawyers gradually taking over the business over the coming years. Gwen, who is 45, has no intention of selling her shares in ACMORE and will remain a senior partner in the business. However, Larry, Jill and Gwen have no immediate intention to sell their shares in either ACMORE or Malachi after the demerger.

Larry, Jill and Gwen also believe that the current corporate structure of ACMORE owning Malachi potentially breaches their legal regulatory body's rules, that forbids a legal incorporated practice or a related entity (which Malachi is) from conducting a managed investment scheme. As Malachi's mortgage business conducts managed investment schemes, Larry, Jill and Gwen state that ACMORE's ownership of Malachi may breach these rules. The partners also state that the penalty for breaching the legal regulatory body's rules could lead to deregistration of ACMORE's incorporated legal practice.

Commissioner's analysis and decision

In examining the current demerger proposal in relation to the relevant circumstances in subsection 45B(8), the Commissioner took into account the following factors:

Both ACMORE and Malachi operate distinct independent businesses. Malachi has its own independent directors and the companies are financially independent of each other both before and after demerger.

A demerger will allow both businesses to pursue independent growth strategies. Malachi will also have new shareholder/directors whose capital and experience should improve the business performance of the company.

Employee share schemes will be implemented immediately after the demerger by both ACMORE and Malachi so that key staff will maintain their employment with the companies and have a vested financial interest in improving the operational performance of the two businesses.

Although Larry and Jill have an intention to sell some of their interests in ACMORE to new equity partners over several years in the future, they assert that they have no immediate intention of selling their holdings in ACMORE after the demerger (paragraphs 73 to 78 of PS LA 2005/21).

Regarding ACMORE's potential breach of the legal regulatory body's rules, it is the Commissioner's position that contravention of an existing rule, regulation or law does not by itself, justify a demerger for section 45B purposes. Rather, it is a relevant factor to consider amongst other relevant factors of the particular case.

If succession planning is a purpose for the demerger, it is likely that the Commissioner will closely examine the issue in relation to section 45B. However, section 45B may not apply in situations where the demerger is being driven by proper commercial considerations that require a demerger and the succession planning will occur at a much later time in the future. In this case the demerger is being driven by those proper commercial purposes, namely the need for additional equity capital for the business of Malachi and the implementation of employee share acquisition arrangements in both ACMORE and Malachi.

It is also significant that the existing ACMORE shareholders will retain the same proportion of their ownership in Malachi as they own in ACMORE before the demerger for a significant period of time after Malachi has been demerged from ACMORE.

In examining the current demerger proposal in relation to the factors mentioned above, the Commissioner accepts that a demerger will improve the business operations of both ACMORE and Malachi (paragraphs 6 to 9 and 22 of PS LA 2005/21). Accordingly, the Commissioner would not make a determination under subsection 45B(3) that sections 45BA or 45C of the ITAA 1936 apply to the proposed demerger.

Examples of how the ATO would assess whether a demerger is undertaken for commercial reasons under section 45B of the ITAA 1936.

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